Image via WikipediaMarket conditions in recent days have turned many arcane financial terms into familiar vocabulary. Words and phrases such as breaking the buck, securitization, counterparty risk and short selling are being used frequently in the media. But many of these terms are not easily understood by the average consumer who don’t deal with them every day.
Given recent news headlines, definitions of a few terms and phrases may be useful as you read daily coverage about the current economic environment:
Auction Rate Securities: Short-term instruments designed to preserve capital while generally realizing higher rates of return than traditional money market investments (for example, municipal auction rate securities, municipal preferreds and action preferred stock). Interest rates or dividends reset frequently, usually every seven to 49 days, via Dutch auction. The interest or dividends received can be 70% to 100% exempt from federal taxes. Issuers include states, municipalities, corporations, utilities, hospitals, housing finance agencies, student loan finance authorities and universities.
Break the buck: When a money market mutual fund's net asset value drops below $1 per share. Money market funds aren't federally insured like bank deposits; therefore, fund assets have an implied promise to preserve capital at all costs and preserve the $1 floor on share prices. These funds are regulated by the Securities and Exchange Commission; rules restrict what they can invest in based on credit quality and maturities with the hope of ensuring principal stability.
Collateralized Debt Obligation (CDO): An investment-grade security (one with a high bond rating such as BBB) backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt but are often non-mortgage loans or bonds. Similar in structure to a collateralized mortgage obligation (CMO) or collateralized bond obligation (CBO), CDOs are unique in that they represent different types of debt and credit risk. In the case of CDOs, these different types of debt are often referred to as “tranches” or “slices.” Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO pays.
Commercial Bank: A full-service institution that offers customers deposit, payment and credit services, in addition to other financial services.
Counterparty risk: The risk to each party of a contract that the counterparty will not live up to its contractual obligations. A counterparty is the other party that participates in a financial transaction. Every transaction must have a counterparty for the transaction to go through. More specifically, every buyer of an asset must be paired with a seller that is willing to sell and vice versa.
Credit Default Swap (CDS): A swap* designed to transfer the credit exposure of fixed income products (securities that pay specific interest rates, such as a bond, money market instrument or preferred stock) between parties. The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.
*Note: a swap traditionally means the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds) or because investment objectives have changed.
Deleverage: A process undertaken by a company in an attempt to reduce its financial leverage, or the degree to which the company is using borrowed money. Financial leverage can be beneficial for a company, but if it becomes too risky or harmful, the company may need to deleverage itself by paying off the amount of debt that it owes.
Derivative: In finance, a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.
Investment bank: An individual or institution that acts as an underwriter or agent for corporations and municipalities issuing securities. Most also maintain broker/dealer operations, maintain markets for previously issued securities and offer advisory services to investors. Investment banks also have a large role in facilitating mergers and acquisitions, private equity placements and corporate restructuring. Unlike traditional banks, investment banks do not accept deposits from and provide loans to individuals.
Money market deposit account: A type of savings account offered by banks and credit unions just like regular savings accounts. However, they usually pay higher interest, have higher minimum balance requirements and limit the number of withdrawals per month. As with bank accounts, the money in a money market account is generally insured by the Federal Deposit Insurance Corporation (FDIC) subject to certain limitations. The recent announcement from the U.S. Treasury regarding money market mutual funds does not affect money market deposit accounts or impact FDIC insurance of such deposit accounts.
Money market mutual fund: A fund that invests in a pool of high-quality, short-term, interest-bearing securities. A money market mutual fund is not a bank deposit and is not insured or guaranteed by Bank of America, the FDIC or any other government agency.
Resolution Trust Company (RTC): A U.S. government-owned asset management company charged with liquidating assets (primarily real estate-related assets, including mortgage loans) that had been assets of savings and loan associations declared insolvent by the Office of Thrift Supervision, as a consequence of the savings and loan crisis of the 1980s. In 1995, its duties were transferred to the Savings Association Insurance Fund of the FDIC. Between 1989 and mid 1995, the Resolution Trust Corporation closed or otherwise resolved 747 thrifts with total assets of $394 billion.
Securitization (or securitized assets): The process of distributing risk by aggregating debt instruments (for example, mortgage loans) in a pool, then issuing securities that are backed by the pool and available for purchase by investors in the secondary mortgage market.
Subprime mortgages: A type of mortgage that is sometimes offered to borrowers with a greater-than-average risk of defaulting on the loan. Lending institutions often charge interest on subprime mortgages at a rate that is higher than a conventional mortgage (often referred to as “prime”) to compensate themselves for carrying more risk.
Short sale: A transaction in which an investor sells borrowed stock, betting the stock will decline with the intention of buying it back at a lower price to realize a profit.
Warrant: Certificate given to its stockholders or bondholders by an issuer that allows the holder to purchase a specific amount of its securities at a set price. A warrant can be sold to another investor if the holder chooses not to exercise the warrant.
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